One of the most misunderstood issues in obtaining a mortgage is why interest rates vary from one person to another or from one lender to another. I am often asked the question, “Why did my neighbor get a better rate than I did?” or “Why did the other lender give me a different rate?”
Many people do not realize that there are numerous factors that can affect the stated interest rate on a mortgage transaction. Following are some common reasons for these differences:
#1 Credit Score
Differences in credit scores can cause wide fluctuations in interest rates between individuals, particularly if you are getting a conventional loan. Conventional loans will often have different rates for each 20 point incremental decrease in credit score. For example, somebody with a credit score in the range of 720-740 is typically eligible for a better rate than somebody with a credit score of 680-700. And the differences may often vary by lender. One lender may have more tolerance for the lower credit score than another. Rates on FHA loans are not as sensitive to variations in credit score as conventional loans.
#2 Loan-To-Value Ratio
Loan-to-value ratio (LTV) is the ratio of the loan amount to the value of the property. In other words if you are buying a $100,000 property and putting down 20% for a loan amount of $80,000, the LTV is 80%. Similarly in a refinance transaction, if your home is worth $200,000 and your loan amount is $120,000, then your LTV is 60% and you have 40% equity in the property. The lower the loan-to-value ratio, the better the interest rate will be. This is because a loan where there is a higher down payment or more equity in the property is considered to be less risky to the lender.
#3 Type of Property
The type of property you are buying can also impact the interest rate. Condominiums are generally considered more risky investments, particularly in recent years. As a result, the interest rate on a condo will be higher than that of a single family home or even a townhome. Other properties that will often have higher interest rates are 2-4 unit properties and manufactured homes.
#4 Use of the Property
Whether a property is to be used as a primary residence, second home, or investment property will also affect the interest rate. There is often no difference between primary homes and secondary homes, but investment properties will in most cases carry a higher interest rate.
#5 Loan Amount
Contrary to what many people think, the smaller loan amounts (under $100,000) also often have higher interest rates. Until you reach the jumbo category of over $417,000, the interest rate will usually be better as the loan amount increases. Once again, each lender may have different thresholds for those differences.
#6 Day/Time the Rate was Quoted
Rates are posted each morning by lenders based on the economic conditions of that morning and/or anticipated economic reports that are expected to be announced. For instance, on days where data is expected to be released related to unemployment numbers, measures of consumer confidence, home sale statistics, etc, you will often see a good bit of volatility in interest rates and changes may occur even throughout the day. If you are comparing a rate quote received on one day to a rate quote received even just a few days earlier, there can be wide variations, simply due to changes in economic factors. When comparing rates, you should also compare quotes received on the same day, or at least ascertain whether market fluctuations have occurred between the dates that quotes were obtained.
#7 Differences in Fees
I often receive calls from individuals who are “shopping” for the best rate, but after inquiring as to the rate, they fail to ask about the related lender fees. It is impossible to compare rates between lenders without knowing the costs associated with that rate. One lender may be offering 4.25% with no origination fee, while another may be offering that same rate, but charging an origination fee of $2000. That is why you should always obtain a good faith estimate, which details the fees to be paid for obtaining the stated rate. Or at a minimum, you should ask what the “APR” will be for the stated rate. The APR is the “annual percentage rate” and takes into account the fees that are being charged. This makes it easier to compare rates between lenders. For example if one lender offers 4.25% stated rate and the APR is 4.65%, while another lender offers 4.25% stated rate with an APR of 4.375%, that means that the one with the lower APR has lower costs associated with it. This also helps to avoid the confusion created by lenders disclosing their fees differently. Although a lot has been done in recent years to ensure more thorough disclosure of rates and fees to consumers, there still exist many variations, making it very difficult to compare good faith estimates among lenders.
#8 Type/Term of Loan Program
Rates vary considerably between FHA, Conventional, Jumbo, and VA loans. While FHA loans often carry lower interest rates than conventional loans, FHA loans will often have higher mortgage insurance. So, again, do not make a decision on the rate alone. A 3.75% rate on an FHA loan may sound better than 4.25% on a conventional loan, but until you factor in the difference in the mortgage insurance rates over the term of the loan, you can’t really determine which is the better rate or lower payment amount. Jumbo loans will carry a higher rate than a conventional loan of $417,000 or less.
And of course, the terms of the loan will also affect the interest rate. The longer the repayment term, the higher the rate. Thus a 30 year fixed rate loan will have a higher rate than a 15 year fixed rate loan. A variable interest rate loan in which the rate is only fixed for a portion of the loan will usually carry a lower rate, but you are then subject to possible future increases in rate.
Take Away: Ask Questions
When shopping for mortgages, don’t be afraid to ask questions. If the lender isn’t willing or able to answer your questions, then you should try somebody else. A good lender will spend the time with you to explain such difference and will not charge any fees to do so. Beware of advertised low “teaser” rates and remember, if it sounds too good to be true, it probably is!